South African inflation surprises on the upside

In January 2008, headline CPI inflation rose by a large 1.1% m/m, with the annual rate jumping to 9.3% y/y from 9.0% y/y in December. This was above market expectations for the rate to remain unchanged at 9.0% y/y. CPIX inflation also rose substantially, up 1.2% m/m in January, with the annual rate increasing to 8.8% y/y from 8.6% y/y in December. This market was expecting CPIX inflation to ease to 8.4% y/y. This is the tenth consecutive month in which CPIX inflation has been above the target range of 3% to 6% and the highest level of CPIX inflation since March 2003.

The main reason for the increase in CPIX during January was food and medical costs. Together these two factors accounted for 1.0% of the 1.2% m/m increase. Although we expect CPIX inflation to moderate during 2008, there is a clear risk that the longer CPIX stays above the target, inflation expectations and wages will be impacted negatively. Already wage demands are being concluded closer to 8.5% than 6%.

During January, food prices (within CPIX) rose by 1.4% m/m, adding 0.5 percentage points to the monthly increase in CPIX. The increase was again extremely broad-based and included sizeable increases in fruit (+4.6% m/m), vegetables (+1.7% m/m), meat (+1.5% m/m), milk (+1.2% m/m), and grain (+1.0% m/m). No key food items declined during the month. Overall, as we have been saying for a large number of months, food inflation at both the producer and consumer level is under severe pressure due to a range of domestic and international factors. There is clearly also upward pressure on processed food prices, which have now moved up steadily from a low of 1.3% y/y in early 2005 to the current level of 13.4% y/y. At the same time international food prices have also been on the rise, creating upward pressure on food inflation in most countries (see charts attached on food inflation in the USA).

The good news from a food inflation perspective is that the high base of food inflation should start to help. In other words, in order for the annual rate of food inflation to maintain the current level of 13.4% y/y, food prices have to rise by a substantial 1.1% every month. This is high given that over the past six months food prices have risen by an average of 1.35% a month.

During the month, the medical category added a substantial 0.5 percentage point to CPIX. This reflects the expected 4.4% m/m increase in various medical expenses that are typically surveyed in January. On an annual basis medical inflation is at 5.7% y/y (within CPIX), compared with 5.5% y/y in December 2007. Medical costs have actually been one of the more well-behaved components of CPIX inflation over the past couple of years, but upward pressure remains given the growing cost of providing acceptable medical care.

Looking forward to the next few months, CPIX inflation is expected to move to a high of around 9.3% y/y in February and March, reflecting partly base effects as well as the upcoming increases in the petrol price. It needs to be stressed that it is not impossible that CPIX could touch 9.5% y/y. The recent larger-than-expected increases in food inflation remain the most immediate concern; however, the upward drift in services inflation (now at 6.0% y/y) is a growing concern given the upward price pressure from institutions such as Eskom. It is also worth noting that CPIX excluding food has broken through the upper end of the target range for the 2nd month since 2003!

For 2006 as a whole CPIX averaged 4.6% y/y, up from 3.9% in 2005 and 4.3% in 2004. For 2007 as a whole CPIX averaged 6.5% and is forecast to average 7.8% in 2008. Importantly, CPIX inflation is expected to remain elevated over the coming year and seems unlikely to fall back into the target range for some time unless there is a very significant moderation in food inflation.

In terms of the real economy, consumer spending on general merchandise (especially furniture and appliances), motor vehicles and housing has clearly slowed in the face of higher interest rates, and a slowdown in real income growth. Furthermore, consumer spending is likely to continue to moderate in the months ahead. Consequently, pushing interest rates higher at this stage runs the risk of severely harming the consumer at a critical time, without substantially bringing down CPIX inflation. While the Reserve Bank needs to contain inflationary pressure, it also needs to guard against undue excessive tightening of liquidity conditions that could lead to recession and increased bad debts and financial risk. It is hoped that the Reserve Bank will be willing to leave interest rates unchanged while it assesses the impact of the recent rate hikes.